How To Keep The ‘Hot Stove’ Trade From Happening To You…

I love learning about new companies, new investment opportunities, and making money in the stock market. But I’m also just as fascinated by the psychology that’s involved with investing, the stock market, and how money, in general, affects people. Especially when it comes to making mistakes…

We are always told that we can learn from other people’s mistakes. But the truth is we never seem to listen. You can tell a child not to touch the hot stove, but chances are good that they won’t really listen until they’ve suffered the physical pain of burning themselves.

When it comes to investing, I see people make the same mistakes over and over again. Oftentimes, it’s because they ignore some basic tenets — like proper position sizing — and blow up their entire account.

For instance, about four years ago I told readers of my Maximum Profit advisory about a young trader who ended up on the wrong side of a short trade. (Remember, when you’re short a company you’re betting that shares of the company will go down.)

After entering his short trade, he woke up the next morning to see that his previous day’s account balance of roughly $37,000 had turned into a negative balance of $106,445.56. He now owed his broker six-figures…

This guy’s story was so widely publicized at the time that practically everyone was talking about it. So you would think that other traders would have learned from this guy’s misfortune, right?

“When History Rhymes…”

Wrong. A few months later another story surfaced about a trader who found himself in a similar predicament. As Mark Twain is often reputed as saying, “history doesn’t repeat itself, but it often rhymes.”

This time it was a 24-year old who bet his life savings buying FitBit (NYSE: FIT) call options on margin. Fitbit, as you may recall, is the company that makes the wearable wristbands and smartwatches that keep track of your exercise and heart rate.

Unfortunately for him, the company reported earnings that didn’t meet Wall Street’s expectations. Shares plummeted on the news, rendering his call options essentially worthless. Unfortunately, he was using margin — or borrowed funds — to make the trade. Here’s a snapshot of his brokerage account:

One Bad Trade Had This Trader Owing $180,000 To His Broker

As you can see, he owed his broker more than $180,000. In his diary of confessions that he posted on his StockTwits account, this young trader talked about how he got behind and kept trying to break even.

But he never did. (I’ve written extensively on this “hope” that traders hold onto when they have a losing trade.)

He also talked about how he learned his lesson the hard way (despite reading about the previous trader’s mistake). And how the stock market isn’t his calling and he’ll never trade stocks again.

It’s easy to understand why he’ll probably never touch a stock again. After all, the psychological damage of incurring a $180,000 loss would likely be enough to scar anyone for life. Many investors are still reeling from damage inflicted on them following the 2008 financial crisis.

For many of us, this is the way we must learn. We have to actually get burned by the stove before we decide that we shouldn’t touch it.

Different Year… Same Mistakes…

There have been many other stories similar to these since then. I was reminded of these two stories when I read a recent New York Times article talking about how the popular trading app, Robinhood, has lured in young traders.

Robinhood, which makes buying and selling stocks extremely simple — and commission-free — has soared in popularity. Mainly amongst the younger generations.

The surge in popularity of Robinhood — as well as other brokerages now offering zero-commission trading — has helped folks ease into trading. Then the health pandemic shut everything down, including games to bet on and casinos to gamble at, and people flocked to the stock market. And don’t try to tell me that none of those $1,200 stimulus checks didn’t find their way to a Robinhood account or two.

To give you an idea of just how many new investors have flooded the market, we need look no further than brokerage firms’ daily trading activity. This metric, which goes by the acronym “DARTs”, or daily average revenue trades, has exploded in recent months. For instance, TD Ameritrade’s DARTs for the first three quarters of 2019 averaged just above 800,000. In June its DARTs soared to more than 3.8 million. The brokerage firm also added a record 661,000 new retail accounts in the second quarter of this year. This was after the brokerage added 608,000 in the first quarter.

Looking at Robinhood, the statistics tell a similar story. The total number of equity positions held by Robinhood users jumped from around 5 million in February to more than 14 million by mid-summer.

And if you think traders have learned their lesson, think again.

That New York Times article I referenced shared the story of Richard Dobatse. According to the article, he “had been charmed by Robinhood’s one-click trading, easy access to complex investment products, and features like falling confetti and emoji-filled phone notifications that made it feel like a game.”

Filled with dreams of striking it rich trading stocks and options, Dobatse unwisely funded his account with $15,000 in credit card advances. After repeatedly losing money, he took out $60,000 in home equity loans to buy and sell more speculative stocks and options.

At one point, he was doing quite well, with a reported account balance of more than $1 million. But that all quickly disappeared, and the New York Times reported his account balance of just under $7,000.

Sure, he didn’t “owe” his broker any money like the two traders in the previous stories. Granted he still owed $75,000 in home equity loans and credit card advances. But he surely made the same mistakes and ended up in a similar spot.

A Word Of Caution

There’s little question that we’re in the midst of an epic trading boom fueled by increased retail participation in the stock market.

Unfortunately, there will likely be a plethora of new stories about novice traders who will make the same mistakes as the ones before them. That includes using excess leverage (margin) to execute trades, failure to properly manage risk (proper position sizing), and trading instruments (options) that are out of their wheelhouse.

I want to issue a word of caution about this… Don’t let it happen to you.

I don’t say this to try and scare anyone away from investing in stocks or options. In fact, I like hearing about people’s newfound interest in the stock market. I think it’s a wonderful thing because it can be a great tool to help build wealth, and it’s a great learning experience.

Plus, as more investors come to the market, it creates more liquidity. And that’s where my most recent recommendation over at Top Stock Advisor comes in…

You see, this month we’re going to take advantage of this surge in new traders and investors by buying the exchange that takes a cut every time we execute a stock or options trade. It’s a classic situation where we’re betting with the house, not against it.

Unlike those novice traders on Robinhood, this is the kind of bet that seasoned pros make. In fact, we’ve made a similar bet like this before. A few years ago, we bought a position in one of the other major exchanges — and it’s delivered a market-crushing return of 161%. If history is any guide, we could see similar success with this latest buy…

Go here now if you’d like to get access to our latest research and learn how to access our full portfolio.